How to Take Money Out of Your Life Insurance

Accessing funds from a life insurance policy can provide a financial resource during various life stages. While life insurance primarily serves to protect beneficiaries upon the policyholder’s passing, certain policy structures offer ways to utilize accumulated value while still living. This flexibility can be beneficial for unexpected expenses, supplementing income, or funding significant life events.

Cash Value Life Insurance

Life insurance policies can be categorized into two main types: term and permanent. Term life insurance provides coverage for a specific period and typically does not build any cash value. Conversely, permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, include a cash value component. This cash value is a portion of the premiums paid that accumulates over time, acting as a savings element within the policy.

The cash value grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn. As premiums are paid, a part goes towards the cost of insurance and administrative fees, while the remainder is allocated to the cash value account. This account earns interest or investment returns, allowing the cash value to increase over the policy’s lifetime. The growth rate can vary depending on the policy type; whole life policies often have a guaranteed interest rate, while universal and variable policies may have growth tied to market performance or declared interest rates. It represents a living benefit that policyholders can access during their lifetime.

Policy Loans

Taking a loan against a life insurance policy’s cash value is a common method to access funds. This is not a traditional loan from a bank but rather an advance from the insurer, with the policy’s cash value serving as collateral. There is generally no credit check or extensive approval process required, provided the policy has accumulated sufficient cash value. Typically, policyholders can borrow up to 90% of their policy’s cash value.

Interest accrues on the outstanding loan balance, similar to other types of loans. Policy loan interest rates are often competitive, typically ranging from 5% to 8%, which can be lower than personal loans or credit cards. While repayment is flexible and often not mandatory on a strict schedule, unpaid interest can compound, increasing the loan balance.

An outstanding loan, including accrued interest, reduces the death benefit paid to beneficiaries. If the loan balance and interest grow to exceed the policy’s cash value, the policy could lapse, leading to a loss of coverage. Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the cost basis (total premiums paid) may become taxable as ordinary income.

Partial Withdrawals

Another way to access funds from a cash value life insurance policy is through partial withdrawals. Unlike a loan, a withdrawal directly removes money from the policy’s cash value. This action permanently reduces the policy’s cash value and often the death benefit. Careful management is important, as excessive withdrawals can diminish the policy’s ability to maintain itself or shorten its lifespan.

The tax implications of partial withdrawals depend on the amount withdrawn relative to the policy’s cost basis. Withdrawals up to the amount of premiums paid into the policy (the cost basis) are generally received tax-free. Any amount withdrawn that exceeds this cost basis is considered accumulated gains and is taxable as ordinary income. This is typically a “last-in, first-out” (LIFO) tax treatment, where the cost basis is assumed to be withdrawn first, followed by taxable gains.

Withdrawals do not need to be repaid, as they are a direct reduction of the policy’s value, whereas loans are an advance that accrues interest. There is no interest charged on a withdrawal. Policyholders should consult their insurer to understand the specific terms and processing times for withdrawals from their particular policy.

Policy Surrender

Surrendering a life insurance policy means terminating the contract entirely in exchange for its cash surrender value. This is a final action that ends all coverage and benefits provided by the policy. Upon surrender, the death benefit is forfeited, and the policy no longer provides financial protection to beneficiaries.

The cash surrender value is the policy’s cash value minus any applicable surrender charges and outstanding policy loans or unpaid premiums. Surrender charges are fees imposed by the insurer for terminating the policy early, which typically decrease over time and may disappear after a certain number of years, often 10 to 15 years. The amount received will be the cash surrender value, usually paid as a lump sum.

If the cash surrender value received is greater than the total premiums paid into the policy (the cost basis), the difference is considered taxable income. This gain is typically taxed as ordinary income. If the cash surrender value is less than or equal to the cost basis, there is generally no taxable gain or deductible loss.